In many cases, the “double-dip” concept in divorce is a misconception. Where valuators see a double-dip, there may not be one. Read on to discover why.
By Robert W. Levis, Business Valuator and Forensic Accountant
Many divorce professionals, both financial experts and attorneys specializing in family law, believe that valuing a closely-held business under an income approach for the purpose of asset division and then considering the income generated by that same asset as available for spousal support constitutes a double counting (double-dip) of the same stream of income. This perspective is summarized by Shannon Pratt (Shannon Pratt Valuations), undeniably one of the most respected business appraisers in our profession:
“Now, the value of the business – the discounted present value – is its future earning capacity. The business value is forward-looking, that is the present value of the expected future cash flow. The present future cash flow is split among his attributive assets, so it’s unfair to use the cash flow again as a basis for alimony, although I am constantly surprised at how often this happens.”
Though widely held, this notion can be a misconception, depending on the circumstances. Put simply: as long as the future income assumed to be generated by the business asset is a return on investment (i.e., “capital”), there is no double counting of the income for property and spousal support purposes. It is only when the future income is a return of the investment that a double counting has occurred. As long as the asset generating the income is not depreciating over time, as is typically the assumption when valuing going-concern business interests, the income generated by the business assets will represent a return on investment and is therefore available for spousal maintenance.
Business income does not create the related business assets but serves as a variable, or tool, with which to estimate or determine their value in the proper context at issue. The assets of a business create income and are valuable for that reason.
Apples and Oranges: Comparing a Closely-Held Business to a Pension
Often appraisers who believe it is unfair to “charge” the value of a closely-held business to the owner-operator divorcing spouse and use the income generated by that same business in the spousal support calculation see an analogy between a closely-held business and a pension. However, there are very significant economic differences between the “value” of a pension and that of a typical closely-held business:
- Once in payout status, a pension is a depreciating asset; and
- The real and assumed rates of return on pension assets are quite small relative to the rates of return on closely-held businesses, particularly small businesses that are involved in most divorce cases.
Accordingly, the income from a pension asset consists of a material return of the asset value, similar to principal payments on a loan. Not so for businesses where the income represents a return on investment and the asset is not assumed to depreciate over time.
Is Personal or Professional Goodwill Included as an Asset?
In most divorce jurisdictions, the value of a closely-held business interest is considered property and subject to division. In most cases where one or both of the spouses are active in the business, courts will divide this business asset in such a way that it goes to one spouse and the “out-spouse” receives property of similar, or equal, value.
The value of the business depends on the standard of value applicable in a given jurisdiction and is usually based on one of two general premises of value:
- Value in exchange – often equal to “fair market value”; and
- Value in the hands of the current owner – often referred to as “investment value (to the owner).”
While a detailed discussion of the above premises and standards of value is beyond the scope of this article, the most important distinction between the two, at least as it relates to the double-dip issue, is whether personal or professional goodwill is included as an asset.
In a hypothetical exchange or fair market value context, personal goodwill, or that of the business owner-operator, is typically excluded from the value of the business absent a contractual right the business entity has to that owner-operator’s efforts. This is consistent with U.S. income-tax law, which utilizes a fair market value standard. In a transaction context, personal goodwill of the selling business owner is usually acquired and captured contractually with non-compete provisions and/or employment agreements.
In a “status-quo” value, or value to the existing owner-operator, where a sale of the business is explicitly ignored, the personal goodwill of the divorcing owner-operator is usually included as a marital asset. In other words, there is no need to distinguish between the business or enterprise goodwill and the personal goodwill of the divorcing spouse.
Many, if not most, divorce professionals who object to using the income of the family business to measure its value and using that same income for spousal maintenance do so in cases where personal or professional goodwill is a material asset subject to division. Nonetheless, the financial issue of the double-dip is the same for any type of business asset, tangible or intangible.
Overview of Business Valuation Methodology
Business valuation methodology is based on two principles: “the principle of future benefits” and “the principle of substitution.” The principle of future benefits states that the value of an investment reflects anticipated future economic benefits. The principle of substitution states that the cost of acquiring an equally desirable substitute tends to determine the value of property. In other words, a person will not purchase a particular asset if a suitable substitute can be purchased at a lower price.
Note that underlying the principle of substitution is an assumed transaction, while the principle of future economic benefits can be used to measure value outside of a transaction context. This distinction often revolves around personal goodwill where the business or professional practice has no value in an exchange context, separate and apart from the owner-operator spouse, but will continue to generate economic benefits as long as the divorcing spouse is assumed to continue to be active and productive in the business post-dissolution.
The value of a non-publicly-traded business is determined with a view toward the intrinsic value of its assets, the value of its income flow, and/or the value in the marketplace. These principles form the basis for three broad approaches used in valuing a business:
- Asset approach;
- Income approach; and
- Market approach.
Most successful businesses generate significant income, over and above a fair rate of return on the business’s tangible assets recognized on the business’s books. In other words, most of the assets of a successful business are intangible in nature and typically include a trained and assembled workforce, systems-in-place, customer or client relationships, and many other intangible assets. For practical purposes, all of these intangible assets are usually combined and referred to as goodwill in business valuation assignments.
Accordingly, specifically identifying all intangible assets that are not recorded on the business’s books is unnecessary. The business valuation expert usually uses an income-based approach (capitalized earnings or DCF method of value) and a market-based approach if there are sufficient and reliable market data from which to apply such a valuation method.
Prevalence of the Income Approach in Business Valuation
Due to the lack of available information regarding market transactions for closely-held businesses, most closely held business appraisals rely heavily on an income-approach method of value. In most cases, where the owner-operator spouse controls the business, the amount of salary and other forms of compensation paid by the business to the owner-operator spouse is income-tax motivated. Accordingly, the business appraiser adjusts, or “normalizes,” the “business income” to reflect a fair market salary for the business-owner’s efforts, usually using a replacement cost concept. By doing so, the appraiser makes a distinction between the income the business generates to compensate the owner-operator spouse for his or her efforts to operate the business (i.e., compensation for services) and the amount of income generated as a “return on investment.” In the application of the “excess-earnings method” commonly utilized in divorce appraisals, this is usually, but mistakenly, referred to as “excess earnings.”
Nonetheless, when an income approach to value is utilized for a business, there is usually an underlying inherent or explicit assumption that the business income will be generated into perpetuity and that the income will continue to grow each year. Because the income is assumed to grow into the future, all of the income is essentially a return on the investment and available for spousal maintenance accordingly.
Business appraisers use the amount of income to measure business value. However, as noted earlier, the underlying business assets generate that income, not vice versa. This fact seems to create some confusion in the context of double-dip, particularly among professionals who lack training in economics and finance.
Example 1: The Return of Capital/Investment
Let’s take an example of a one-year bond to illustrate the return of capital/investment. Assume the marital estate owns a $100,000, one-year bond that generates 10% annual interest at the time of the divorce. Assume further that its face value and market value are the same.
At the end of the year following the divorce, the spouse who received the bond will receive $110,000 ($100,000 principal and $10,000 interest). It is doubtful that anyone would say that the $100,000 of the bond principal the spouse receives at the end of Year 1 is income available for spousal maintenance. Most judges or divorce professionals would consider it a double counting to do so.
Example 2: A Hypothetical Dental Practice Valuation
In light of the Bohme v. Bohme decision from the Ohio Court of Appeals (2015 Ohio App. LEXIS 325 [Jan. 30, 2015]), it may be useful to create a hypothetical dental practice valuation. In Bohme, the issue was the value of the husband’s dental practice. The trial court credited the income-based valuation of one of the husband’s experts for the purpose of valuing the business. But, in terms of spousal support, the court rejected the expert’s proposition to attribute only half of the annual corporate income to the husband since using the total income would be to use the income that served as the basis for valuing the business a second time. The Ohio Court of Appeals affirmed the trial court’s decision primarily on fairness grounds. Under its computation, the present value to the husband of the additional income stream would be almost $1 million more than the determined value of the business, the appeals court said. No reasonable person would believe that there was double counting to the husband’s detriment.
Dental practice valuation assignments are relatively common in divorce cases because:
- There are many such businesses in virtually all areas around the country;
- These are professional practices that are routinely bought and sold by third parties; and
- The economics of general dentistry practices are relatively consistent across the country.
Exhibit 1 contains a summary of historical operations of a hypothetical dental practice and its divorce value using an application of the capitalization of earnings method.
Those professionals who believe it is a double counting of income to charge the owner-practitioner spouse $450,000 for his or her dental practice and use all $300,000 of income generated by the practice each year typically argue that only the $210,000 in fair market compensation for the owner-practitioner’s efforts should be considered for spousal maintenance. This, however, ignores the very real fact that at some point the dentist will likely choose to retire and can, in fact, sell this asset to a third party. Until such time, the owner-practitioner will enjoy the economic benefits of the $90,000 return on its value each year.
Assuming the divorced spouse sells the practice for $450,000 and takes a dental associate position with another practice earning $210,000 per year, then the economic circumstances will have changed and the income available for spousal maintenance will be considerably lower (assuming the parties can modify the earlier support award).
Salable v. Nonsalable Professional Practices
Some professional practices are transferable and commonly bought and sold. CPA and dental practices are the most actively transferred professional practices. Other types of professional practices are typically more difficult or impossible to transfer to third parties for any substantial economic value.
Let’s assume we have a highly marketable CPA practice and a nonsalable specialty physician practice. Assume that each practice generates $100,000 per year in earnings over and above a fair compensation to the owner-practitioners. Furthermore, assume the CPA practice will be sold for its fair market value and the nonsalable practice will be closed and its owner-practitioner will retire at the end of Year 5.
Exhibit 2 illustrates the economic differences between the two using the indicated assumptions.
The only difference between the above two practices is the CPA practice can be sold at the end of the assumed holding period for the same amount as its current value. In the nonsalable professional practice, the earnings for the five-year holding period consist of both a return on its value and a return of its value because it has no value at the time of assumed retirement. To include the return of investment, or capital, in the income stream considered for maintenance would be a double counting of that income. The return on capital is income available for spousal maintenance.
“An Interview With Business Valuation Expert Shannon Pratt,” Family Lawyer Magazine, May 23, 2014. www.familylawyermagazine.com/articles/interview-shannon-pratt
The excess earnings method adds the value of the business’s tangible and intangible assets and subtracts any debt to arrive at an equity value. The proper term for “excess earnings” using this method is the “normalized” income over and above a fair return on the business’s tangible assets and, thereby, assumed to represent a return on the business’s intangible assets. The owner-operator fair market compensation adjustment is made to normalize income associated with both the tangible and intangible assets of the business.
Robert W. Levis, CPA/ABV, ASA, CFE, specializes in business valuations, damage quantification, and forensic accounting. Having valued hundreds of businesses in many industries, he is an experienced business appraiser; he is also an experienced expert witness having testified in numerous judicial jurisdictions regarding business and intangible asset values, and forensic accounting matters. www.levisconsult.com.
Business Valuation and the Double-Dip Problem
The double-dip issue comes down to how one looks at the owner’s future tenure at the business. If one assumes that the owner will remain with the business and earn compensation as he or she has per the valuation analysis, the non-owner spouse might be shortchanged if the court decides to use only “reasonable compensation” for support purposes.
The Persistent Problem of “Double-Dipping”
One of the most prevalent problems in family law cases involving a business or professional practice valuation is the “double-dip”: computing a value based, at least in part, on the spouse’s future earnings for property division, and then using the future earnings capacity as a basis for determining spousal support or alimony payments.